Rate Beaters

FOR THE GENTLEMEN WHO run the Arlington Hill Debt Strategies Fund, a two-year-old, $100 million hedge fund that invests in global-debt instruments and currencies, a little can mean a lot.

While your typical equity hedge fund may make million-dollar bets that the price of stocks will fall precipitously over a short period, or be winners over the longer haul, Arlington Hill co-founders Conrad Voldstad and Steve Gregornik make smaller wagers on, say, whether interest rates in Europe will rise or fall, or which part of the yield curve will produce the best result for a given quantity of risk. Or they may try to make money on the difference in yield between U.S. Treasuries and government-agency debt, buying one and selling the other and pocketing the difference.

"We take what you might call an incremental, opportunistic approach to investing," says Voldstad. Adds Gregornik: "We don't like crowds and try to make money by placing modest investments over a very large playing field."

Their credentials, however, are anything but small: Voldstad was the first head of the
J.P. Morgan
global swaps group in the 1980s and co-head of
Merrill Lynch
's global debt markets in the 1990s. Gregornik also worked at Merrill in the late 1980s and 1990s, running, among other things, the firm's European debt-options business, as well as foreign-exchange and local-currency debt trading for global emerging markets.

Arlington Hill, formed in November of 2002, is one of the newest members of a small but growing fraternity of hedge-fund firms offering alternative strategies and risk diversification to investors in equity hedge funds. The fund's aim is to avoid losses and produce solidly decent returns year after year, regardless of market conditions.

In this year through Dec. 17, the fund managers generated a 3.74% return, roughly double the median posted by the 156 market-neutral arbitrage funds surveyed by MAR/Hedge. It achieved these results through such moves as trading municipal interest-rate swaps against normal rate swaps, betting on the shape of the U.S. yield curve, the direction of interest rates in Norway and the price of interest-rate options in Europe.

In 2003, its first full year of operation, Arlington Hill posted an 8.48% return (after fees). That was slightly below the median 8.8% of funds surveyed by MAR/Hedge. But the founders were unfazed. "Considering it was our first full year as a fund, 2003 was a successful year -- given that we made money in 11 out of 12 months," affirms Voldstad.

"In fact," he says, "our caution to establish a positive track record held back our returns, because we sized our trades at levels that a more mature fund would have considered too low."

With $106 million in assets, Arlington Hill is one of the smaller fixed-income, relative-value hedge-fund money managers, dwarfed by the likes of Vega Asset Management, with $12 billion; Brevan Howard, with $4 billion; and Blue Crest Management, with $500 million. But as Voldstad likes to point out, small can also mean nimble.

"We're just out of the gate, but we think we can significantly increase our size in the next two or three years," he says, then adds: "Given our conservative bent and disciplined approach to investing, we will maintain some limits on our growth."

Together, Voldstad and Gregornik represent four decades of experience in the heady world of interest-rate swaps, currency hedging and other derivatives trading. The two men worked together at Merrill Lynch between 1988 and 1999, with Voldstad, currently 54, holding the position of managing director and co-head of global debt markets and founder and CEO of Merrill's AAA derivative-products subsidiary.

Voldstad was also a member of the six-person oversight group formed by the major Wall Street firms that participated in the $3.6 billion bailout of the hedge fund Long Term Capital Management. The fund threatened to rock the international banking system in 1998, after suffering catastrophic losses -- largely in U.S. Treasuries -- when the Russian debt default battered global bond markets.

FOCUS ON: Arlington Hill Debt Strategies

Investment Style: Relative value and macro-directional trading in interest-rate and currency markets of developed countries.

How to Play It: Building exposure to managers who specialize in biotechnology, energy and Japanese stocks. Has 22% of the fund invested with long-short hedge funds specializing in U.S. stocks, with a slight tilt toward stock-market bulls.

From

Inception

YTD

Total Returns*

11/1/2002

2003

2004*

Arlington Hill

12.55%

8.48%

3.74%*

*As of Dec. 17

Source: Arlington Hill

The Long Term Capital assignment left a deep impression on Voldstad, strengthening a conservative bias that already set strict and high standards for risk tolerance.

"We have a very disciplined, consistent and conservative approach to risk," he says. "In setting up the fund, we installed a number of controls -- stop-loss safeguards and concentration limits on individual positions as well as value at risk and capital at risk constraints on the portfolio as a whole -- which keep our risk exposure under control."

He adds, "We might occasionally miss a strong upside surge, but our emphasis is focused on not losing much money as well as trying to make decent returns in the market."

A Chicago native and graduate of Northwestern University, Gregornik, at age 28 in 1995, was named a managing director at Merrill Lynch, becoming the youngest person to join those ranks. He ran the company's European debt-options business and later the global local-currency debt business, a group devoted to the trading of government bonds, currencies, credits and derivatives denominated in local emerging-markets currencies.

The duo's long-standing contacts in the finance business helped bring them into contact with RMF Investment Management, a Swiss fund-of-funds manager that seeds hedge-fund startups. They were able to secure a $40 million investment from the RMF, a subsidiary of Man Group, a London-based global leader in alternative investments.

"The investment allowed us to start trading and operating quickly," says Voldstad. "It costs a lot to establish a new fund and underwrite your start-up period. In our case, this seed money allowed us to pay our bills and grow our resources. A smaller investment of, say, $10 million or $20 million, would have forced us to spend more time on marketing the fund and less on trading and developing a track record."

Neither manager draws a salary, depending instead on performance fees, which are 20% of upside returns. They are always on the lookout for new investors: The minimum investment size is $500,000.

The fund has attracted $50 million in new cash and asset growth since starting up. With the growth of the fund, the managers have increased the trading team to four professionals and plan to add additional traders in 2005.

"We would like to have a team in place that could trade all major currencies and interest rates," says Voldstad. "This may mean specialists in mortgages or perhaps a trader to focus on Australia and New Zealand. By increasing the number and depth of the markets followed, the managers believe they can improve returns."

The fund does not invest in equities or commodities. Arlington will also take only smaller currency bets, and will do so until it has specialists following these markets more closely.

"We consider ourselves cautious but opportunistic investors," explains Voldstad. "That means we react to market opportunities, such as a plunge in the price of options or a sudden widening of the spread between governments and interest-rate swaps."

It's a business filled with strange but critical terminology, like "straddle premiums," "short tails," "butterflies" and "bips." However obscure, the terms can easily translate into profits in the hands of the right traders.

One of the fund managers' most profitable trades this year came from an opportunity involving Norwegian interest rates. Shortly after the U.S. released a favorable employment report last April, interest rates around the world rose dramatically in anticipation of tightening by central banks, particularly the U.S. Federal Reserve. The Norwegian yield curve implied that rates would rise almost as fast as those in the U.S.

But "the fundamentals told a different story," says Gregornik. "Norway was a country with a sizable current-account surplus [more than 13% of gross domestic product], a currency that was strengthening relative to the U.S. dollar and the euro, and whose own central bank had viewed the country's inflation trend to be lower than its desired target level." Norway, the world's second largest non-OPEC exporter of oil, received a further boost this year from rising oil prices.

Using some analytics they developed as derivatives traders, the managers identified the best investment point on the curve and the best instruments to express this view. The firm received a payment based on a fixed rate that was nearly 4% on a series of one-year swaps starting in one year's time. "With the central bank holding overnight rates steady at 1.75%, we saw little chance that one-year rates would be so high in the near future," Voldstad says. "We started to liquidate these positions when the market settled down."

Conversely, bets on interest rates in the U.S. and U.K. have caused the fund's greatest loss this year. The managers figured long-term rates, which had been declining in the wake of the Fed's lifting of short-term rates in the summer, would start to rise. But in fact, they continue to fall. In Britain, the managers bet two-year interest rates would rise, but they, too, kept declining.

"The Fed should raise rates at least one percentage point next year, and the 10-year Treasury yield of about 4.2% offers little reward in this context," says Gregornik. "The European Central Bank has kept short-term rates at 2% for over a year and it believes it has been very accommodative, and remains concerned about inflation. Futures contracts are pricing in short-term rates of only 2.5% in Europe 15 months from now. Similarly, futures contracts in the U.K. price in flat yields for 3&frac12; years. The economy in Japan has slowed somewhat but is still growing, and 10-year government rates are back below 1.4%."

For now and the future, Voldstad and Gregornik will continue to prowl global financial markets in search of new market opportunities wherever and whenever they arise, while maintaining the strict risk controls that will help insulate them from the sometimes extreme volatility experienced by other hedge funds.

"We think we can earn 7% to 12% over money rates," says Voldstad. "While last year we achieved this objective, we won't do that this year largely because we haven't seen the opportunities that we saw in 2003. As a result, we have been more conservative than we would like to be -- but in our experience, it pays to be patient. We are confident that there will be reasonable opportunities in and outside the U.S., which we will be able to identify and which will create some pretty attractive returns," he says.

Whether that means scouring for opportunities in Scandinavia, Japan or even Down Under, Arlington Hill is ready to deal.

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